Can sub-5% yields be justified for super-prime property? Richard Gwilliam, Emma Harding and Fulgence Kayiranga assess the investment rationale behind trophy assets
The recent performance of central London commercial real estate has been raising questions for many UK-based investors. Although the UK economy is in recession and the rest of the UK property market remains weak at best, property in central London has experienced continued capital growth. In particular, a certain type of commercial real estate has continued to attract strong investor interest, commanding ever higher prices – the so-called ‘trophy assets’.
Trophy assets are known throughout the industry for their iconic image and premium price tag, although a standard, widely-agreed definition does not appear to exist. Nevertheless, these buildings are recognised as having unique architectural or historic features that set them apart. They will also be found in prime locations, which partly explains their high price tag, ensuring that they remain the preserve of a few deep-pocketed investors.
The lack of a standard definition might also explain the limited knowledge and performance data that is available. Equally, the often heard assertion that they have qualities of resilience, particularly during times of severe economic stress, is difficult to substantiate.
On conventional return metrics, these assets at today’s very low yields fall short of most UK investors’ return expectations. Domestic institutional investors, such as PRUPIM, have in recent times viewed trophy assets, and more generally prime central London assets, as overpriced and unable to deliver the returns they require. Indeed, buyers of these assets are now dominated by other types of investor, the vast majority of which are from overseas.
It would appear that overseas buyers either value these assets differently and do expect attractive returns, or that their appeal lies in other intangibles or qualities that can’t easily be captured through conventional quantitative assessments.
This article explores what it might take for purchases to make sense at current pricing.
One important factor investors usually consider when buying property is the rental growth outlook. Our analysis suggests that, at current low yield levels, which are expected to rise in the future in order to reach fair value, rents for prime retail and office assets in the West End would need to rise by a very optimistic 10% in real terms over each of the next five years in order to deliver an attractive long-term real return of around 5% per annum.
However, the consensus outlook for rental growth in these markets, although better than the rest of the country, remains relatively lacklustre, reflecting continued economic weakness. As such, it seems unlikely that these prime or trophy assets will be able to produce the kind of medium to long-term returns that we believe are required to justify investing at such pricing.
Of course, overseas investors are not looking at pricing in quite the same context as a domestic institutional investor. For a start, there is currency to take into account. Take prime West End offices as an example: from a UK sterling perspective, the market has rebounded significantly from the trough that was reached in 2009 and, at around 20% below their peak value in 2007 (which itself was a time of extreme overpricing), current capital values do not look attractive in light of the mediocre economic and rental outlook.
However, since 2007, sterling has depreciated, today being around 25% weaker versus the US dollar and 35% weaker versus the Chinese yuan and the Singapore dollar. When the UK’s weaker currency is combined with change in capital values, such assets may not necessarily look overpriced for an overseas investor. For example, in various Asian currency terms, prime West End office capital values are still not far off 50% below their peak value, potentially making them a much more attractive proposition for these buyers than for sterling-based investors. Even from a European investor’s perspective, these asset capital values are around 35% lower than they were in 2007.
An overseas investor will also be considering the rest of the world. Even if trophy assets in London look expensive in isolation, they may actually be better value than those in other parts of the world. For example, prime office yields in Hong Kong and Singapore are in the twos and threes, compared with the fours and fives of prime offices in London. In addition, a globally diversified investor would almost certainly look to include London property in their portfolio, given its importance as a global market.
With global investors less likely to consider second-tier markets in the UK (rightly or wrongly), investing in London assets, even at expensive pricing, could add UK exposure and boost diversification, thereby reducing portfolio risk. While the global investor’s portfolio performance may not necessarily be improved, their risk-adjusted returns might be.
In today’s economic environment, risk is a very important factor for investors. Firstly, risk aversion has pushed the yields of government bonds, the risk-free rate, down to record low levels. So while trophy assets and other prime property in London may appear overpriced, it still seems better value than many competing investments for risk-averse investors. However, it is clear that property, no matter how prime or trophy, still carries some level of risk.
It is not in dispute that properties at the prime end of the spectrum are less risky than those at the secondary end, due to more secure income (generally, they will have stronger covenants on longer leases), more chance of attracting and retaining tenants to pay the rent, and higher liquidity should the investor want to sell. In an international sense, property in London also has other risk-mitigating factors, such as an investor-friendly legal system with well-respected property rights and a transparent transaction process, a deep, open, mature property market aiding liquidity, and relatively long leases with upward-only rent reviews.
Against the backdrop of the euro-zone crisis, property in the UK has also been held up as a relative safe haven in Europe, being non-euro denominated. More generally, many investors have viewed investing in a prime/trophy property not only in London, but also in other cities around the world, including core parts of Europe such as Paris and Munich, as being a safe haven that is a good place to park their capital.
One investor we spoke to has taken euro-zone fragmentation as its worse-case scenario. As a result, its most acceptable option is to go after trophy or very good prime assets where reasonable prices can be achieved. But it considers the premium price tag fully justifiable in order to preserve capital in an environment that lacks enough safe assets to do the job properly.
However, little evidence has been produced to bolster the claim that these types of properties are indeed safe havens. In times of severe economic stress, including a potential euro-zone break-up and economic collapse, would these trophy assets prove to be safe havens? Do they actually provide capital protection to investors during a downturn?
Although data on trophy assets is limited, we have taken prime rent and yield data for known trophy asset buildings and compared their movements with that shown in prime and IPD data to test relative resilience over the 2007-09 downturn. Based on the sample, trophy assets did not prove to be good at preserving capital. Indeed, the study showed falls in rents and adverse yield shift that were generally in line with the movements seen in their wider prime peer groups – and these movements were also often worse than those experienced by the ‘average’ market, as measured by IPD. In other words, trophy assets appear not to have provided capital protection in either absolute or relative terms. Admittedly, these assets did tend to rebound quickly once they had reached their trough, generally in line with the prime market as a whole.
This analysis does raise questions about the assumption that such assets will prove to be safe havens in a crisis – for example, if the euro-zone collapsed. While assets in London may perform relatively better than assets in other parts of Europe in this situation, it is likely that they will still suffer significant falls in value. It seems highly probable that rental values will be hit hard, and yields will struggle to hold at such low levels. It is notable that yields for other properties in the rest of the UK and further up the risk curve are much higher than prime London yields and, indeed, much higher than where they were before the 2007-09 downturn. Prime London yields on the other hand are close to where they were back in 2007. As such, riskier property assets already have a significant relative risk premium, or compensation, priced in, whereas prime London properties appear to have little ‘give’ in terms of risk compensation.
Of course, the definition of a safe-haven asset might be narrower still, perhaps only relating to those assets that have a tenant who will continue to pay the rent when crisis hits. However, it must be noted that even the most outwardly ‘safe’ tenant might not prove so resilient when surrounded by such uncertainty – after all, Lehman Brothers and AIG were still rated at least AA very shortly before they collapsed and even governments are no longer assumed to be truly safe bets.
An often heard argument for trophy assets is that prime West End offices are ‘like gold’. Gold, of course, is considered the traditional safe haven, and it did perform well during the financial crisis. However, comparing movements in gold prices with both prime and IPD West End indices indicates little correlation between the two asset types.
Indeed, when gold prices were rising yearly during the financial crisis, negative yield impact and capital decline in the prime West End market was actually at its worst, suggesting that these assets were behaving the exact opposite of a safe haven. Analysis suggests that movements in gold prices and prime West End office yield tend to show the strongest correlation during property market upturns.
Also, investing in trophy assets because of the safe haven argument might only be the right course of action if the safe havens themselves are the right thing to be in. The outcome of the euro-zone crisis is far from decided, and it is far from certain whether it will get worse or even collapse. While there are obvious downside risks, there are upside risks too, as shown by the increasing determination of the ECB to tackle the problem. As such, safe havens could underperform significantly – it should not be forgotten that the price of gold fell by almost 20% after peaking in the summer of 2011.
The comparison of trophy assets with gold is notable in another way – in that they may sometimes be bought because of what could be called the ‘bling factor’. Some investors might buy trophy assets as a display of wealth, in the same way that someone might buy luxury goods like jewellery or a Ferrari. This is highly questionable as an investment rationale, although it is possible that it serves a marketing purpose, advertising the investor or the fund to potential clients and helping their brand.
This is the case from the perspective of some tenants, too – there is an increasing level of occupier demand seeking brand recognition via association with trophy assets worldwide. Property agents have reported emerging markets enquiries seeking a particular image by relocating to the most prestigious, recognisable trophy asset, regardless of the cost. That, of course, can boost the rental value and therefore capital value of these assets. However, it is far from guaranteed, and there are notable new potential trophy assets in London that are struggling to attract tenants – investors should remember that the Empire State Building in New York was for a long time nicknamed the ‘Empty State Building’.
Investors considering purchasing trophy assets and other prime properties in London at today’s elevated prices do need to think carefully about why they are doing so. It is possible that it makes sense to them and that their decision is justified. However, it also seems very possible that they are doing so for the wrong reasons or that they are misguided in their assumptions. If so, their investments may end up losing a lot of their shine.